March 31, 2021
Firms that embrace ESG issues are gaining advantage in risk management and value creation.
As evidence builds validating the link between financial performance and environmental, social and governance (ESG) factors, coupled with looming regulatory intervention, investment firms are beginning to take notice. Private equity has traditionally steered away from publicly reporting nonfinancial metrics. This reluctance is evolving quickly with mounting pressure from several sources. One source that validates the growing adoption of ESG-related reporting is the Principles for Responsible Investment (PRI) initiative, which now has more than 500 private equity funds formally onboard and committed to incorporating ESG criteria in their reporting. Private equity has responded to criticism around the lack of ESG reporting by stating that it is simply too difficult.
A very real challenge for private equity firms lies in how to consistently reflect the impact ESG criteria has on investment-related decision making. There are no accepted standards on data formats. There are numerous data collection solutions, sources and providers with no consensus around a definitive approach. ‘Greenwashing’ continues, with private equity simply paying lip service.
To help build credibility, firms have to demonstrate their commitment to factoring ESG metrics into their investment risk management and valuation methodologies, and be able to show the performance and value-related impacts.
Despite the fact that more and more private equity firms are integrating ESG factors into their investment strategies, there is still not alignment and understanding as to the reasons why, tools/technology that can be leveraged, or related best practices.
The vast majority of firms are going down the ESG path because public opinion, investors and stakeholders are all expressing they value a solid sustainability investment plan.
ESG regulation is here
The legal provisions of the Regulation (EU) 2019/2088 on Sustainability-Related Disclosures in the Financial Services Sector just took effect in March 2021. In response to this legislation, there are two key things private equity can take action around:
- Mind shift: Embrace the notion of sustainability risk. This is defined as an ESG event or condition that can have a material impact (positive or negative) on the value of an investment.
- Level of effort evaluation: Firms are underestimating the need to evaluate the resources, expertise and systems needed to integrate ESG monitoring and reporting into their standard practices. This includes ESG-related data collection on existing portfolio companies as well as investment targets. This data needs to be published with clearly defined best practices that enable a firm to consistently apply ESG criteria to current investment methodologies with understood outcome scenarios.
Two primary ESG criteria adoption considerations: risk management and value creation
Private equity firms are adopting ESG factors into their investment strategies primarily as a way to reduce risks associated with negative events. Fewer firms are considering prospective investment targets based on their environmental and social policies and behavior as a value creator.
We are seeing the larger hedge funds and asset managers already integrating ESG factors into investment decision-making with the objectives to reduce risk and, ultimately, enhance investment value.
This graphic below shows how ESG criteria adoption is trending. Data shows funding commitments trending up. The prevailing opinion is this trend will continue.
Near-term efforts of private equity are focusing on the minimum levels of ESG monitoring and reporting necessary to provide air cover for portfolio companies. The intent is to mitigate risks and related negative optics associated with ESG violations.
Survey results from a recent Ernst & Young research report show that only 24% of private equity firms treat environmental, social and governance matters as a priority and had integrated ESG factors into their investment management processes. But 48% of investors said they are not seeing an acceptable number of choices in private equity and venture capital firms practicing sustainable investment. The US lags Europe significantly in the adoption of ESG factors in investment. 66% of European firms are offering ESG-related products, while only 28% of US fund managers are doing so. Most of the research data around ESG adoption falls along these lines, and none of it bodes well for private equity in terms of adoption trends.
The data challenge
One challenge private equity firms face is sourcing the right information, along with a clear and comprehensive way to incorporate ESG criteria metrics into their strategy.
The volume of data can overwhelm portfolio managers trying to understanding how to best incorporate the data to bring meaningful and actionable insights. Some firms are still grappling with the belief that incorporating ESG data into their investment strategy presents more difficulties and challenges than the value it could deliver.
It is important to note that ESG data is only one component of the investment picture, and should never be used as an isolated set of metrics. The thoughtful correlation of ESG data and metrics with standard financial and operational performance reporting will bring meaningful insights into the investment and risk management picture.
One example of a firm embracing sustainability
New Mountain Capital is committed to a sustainable and responsible investment approach. Part of its playbook is focused on improving ESG issues in each of its portfolio companies.
New Mountain Capital has incorporated 24 key ESG metrics into its due diligence and performance management process for private equity and credit investments. The firm holds itself accountable by publishing an ESG Annual Report for investors that summarizes progress and specific actions taken to improve ESG metrics at each portfolio company.
The future is becoming clear. Mounting interest by investors and stakeholders will continue to pressure private equity to adopt ESG criteria into their investment management strategies and planning. The introduction and evolution of new technologies, regulation and standardization will help drive ESG adoption and help firms incorporate a sustainable investment approach into their playbooks.